Tag: Options

A derivative is a financial instrument whose value is derived from another underlying asset. The underlying asset could be

Stock

Interest rate or foreign exchange rate

Index value such as a stock index value

Commodity price or index

Value of a derivative is ‘derived’ from another variable

The four basic derivatives types are

Forwards

Futures

Options

Swaps

A. Forwards

A forward contract gives the owner the right and obligation to buy a specified asset on a specified date at a specified price. On the specified date, the underlying asset will be received or delivered at this price.

The seller of the forward contract has the right and obligation to sell the asset on the date for the price

At the end of the forward contract, at “delivery,” ownership of the good is transferred and payment is made from the purchaser to the seller

Generally, no money changes hands on the origination date of the forward contract

However, collateral may be demanded

Delivery options may exist concerning the

quality of the asset

quantity of the asset

delivery date

delivery location

If your position has value, you face the risk that your counterparty will default.

Futures contracts are standardised and are be traded on exchanges. Default risk is lower as they are cleared on exchanges.

Futures and Forwards are identical in structure. The key difference is

Futures are exchange traded and hence have no counterparty risk, Forwards are OTC (Over the Counter) products

Futures are standardized contracts (done by the Exchange), Forwards are customized by the parties.

C. Options

These are derivatives with the following features

The buyer of an option

Has the right

but not the obligation

to buy (or sell) a particular product

on a particular date (Exercise Date)

at a particular price (Strike or Exercise Price)

The seller of the option

Receives a premium for selling the right

Has the obligation to deliver the product when the buyer exercises the option

An option seller is also called a ‘WRITER’

Listed Options are standardised and are traded on exchanges

OTC Options are customized and not traded on exchanges

Call Options

A call option is a contract that gives the owner of the call option the right, but not the obligation, to buy an underlying asset, at a fixed price, on (or sometimes before) a pre-specified day, which is known as the expiration day

The seller of a call option, the call writer, is obligated to deliver, or sell, the underlying asset at a fixed price, on (or sometimes before) expiration day

The fixed price is called the strike price, or the exercise price.

Put Options

A put option is a contract that gives the owner of the put option the right, but not the obligation, to sell an underlying asset, at a fixed price, on (or sometimes before) a pre-specified day, which is known as the expiration day

The seller of a put option, the put writer, is obligated to take delivery, or buy, the underlying asset at a fixed price, on (or sometimes before) expiration day.

The fixed price is called the strike price, or the exercise price.

Options that can only be exercised at expiration are called “European” options.

Options that can be exercised any time until expiration are called “American” options

D. Swaps

A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions

Involves the exchange of cash flows arising from specific

Assets

Liabilities

To exchange one set of cash flows for another without involving the transfer of the asset or liability itself

A swap is like a portfolio of forwards. Each forward in a swap has a different delivery date, and the same forward price